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A tale of two Mexicos

Mexico’s President Enrique Peña Nieto, pictured last week in Panama.
By Jaana Remes & Luis Rubio
Project Syndicate
Country must fix key defects to improve anaemic GDP growth

MEXICO CITY — Mexico is making headlines of late. For a change, they are mostly positive. January marked the 20th anniversary of the North American Free Trade Agreement, the treaty that created a single market with the United States and Canada, and helped to propel Mexico into the top ranks of manufacturing exporters. The reform agenda of President Enrique Peña Nieto has received global attention. And, in recent months, global leaders in auto and food manufacturing have announced multi-billion-dollar investments in new facilities.

Indeed, in a world that has grown nervous about emerging economies, Mexico stands out as an island of opportunity, with a stable fiscal position and the prospect of rising demand for its goods as the US recovery gathers momentum. Yet there is another side to the Mexico story. For all of its successes under NAFTA and other market-opening devices, the country has recorded relatively slow GDP growth. For the past 20 years, annual GDP growth in Mexico has averaged about 2.7 percent, which is low by emerging-economy standards and not enough to raise living standards substantially across a growing population.

The main factor behind Mexico’s anaemic growth is chronically weak productivity increases. If Mexico cannot find ways to spur higher productivity soon, it could be headed to two percent growth, rather than the 3.5 percent that is widely expected. That is because ageing population and a falling birth rate will slow the flow of new workers into the labour force, the source of more than two-thirds of GDP growth in recent decades.

The solution to the productivity problem is easy to state but difficult to accomplish: the country must bridge the widening gap between the “two Mexicos” — the agile, dynamic, post-NAFTA modern economy (the “Aztec tiger”) and the traditional economy of slow-growing, unproductive traditional businesses. These two Mexicos are pulling in opposite directions, which explains why three decades of reforms to open markets, privatize industries, embrace free trade, and welcome foreign investment have failed to raise growth rates. This is the central finding of our recent research.

Modern, highly productive, and globally competitive Mexico has flourished under NAFTA and other rounds of market liberalization. Today, Mexican multinationals such as FEMSA, Grupo Alfa, Grupo Bimbo, Grupo Lala, Mabe, and Walmex have become leaders in some of the most competitive markets in the world.

But policy changes have barely touched the other Mexico, where traditional enterprises operate in the same old ways and are experiencing falling labour productivity. While the largest modern companies have been ratcheting up productivity by 5.8 percent annually, productivity at traditional Mexican enterprises — tiny stores, bakeries, low-skill manufacturers — has been declining by 6.5 percent. Worse, employment is growing faster in the traditional economy, in effect shifting labour from high-productivity to low-productivity work — the opposite of what any economy wants.

Broad priorities

The question looming over Mexico today is whether Peña Nieto’s reform agenda can fuel economic growth in both Mexicos. Two broad priorities need to be addressed:

— Mexico must work to transform the traditional sector from a low-productivity, low-wage trap for workers into a dynamic source of growth, innovation, and employment. The share of workers employed by medium-size Mexican companies — a potential engine of job growth — dropped from 41 percent in 1999 to 38 percent in 2009.

— Mexico needs to create a level playing field on which all companies can blossom; today regulatory preferences, tax policies, and other structural obstacles limit the growth of the modern sector and perpetuate the traditional and informal sector.

Of course, no magic wand can turn small business owners with limited capital and skills into entrepreneurs. But conditions encouraging more small companies to join the formal, modern economy can be created.

For starters, incentives that reward companies for remaining small, inefficient, and informal should be removed. To take one example, small business owners subscribe to electric service as individual consumers and can even qualify for subsidies of up to 80 percent. Likewise, traditional markets and street stalls pay no sales taxes. Despite recent labour-market reforms, limitations on layoffs and temporary workers continue to encourage even large companies to hire full-time workers through third-party agencies (and thereby avoid burdensome restrictions).

Access to capital is another barrier. Mexico lags far behind its emerging-market peers in outstanding bank loans. We estimate that Mexico’s annual credit gap — the difference between what companies would be expected to borrow and what is actually loaned — is US$60 billion a year. Three-quarters of that gap is under-lending to small and medium-size enterprises, which in other economies create new products and services and deliver the most employment growth.

To achieve the second goal — making Mexico a place where modern companies thrive — Mexico needs not only to remove obstacles such as restrictive zoning, which limit the growth of modern stores; it also must improve the overall business environment and ensure that contracts can be enforced. Despite Mexico’s energy riches, for example, the cost of electricity for commercial customers is 73 percent higher than for US businesses.

Moreover, Mexico would need to invest US$71 billion annually to bring infrastructure to the level needed to support 3.5 percent growth. Mexico also needs to continue to raise educational attainment to prepare the labour force for modern-sector employment.

The private sector has a critical role to play in bridging the two Mexicos. Even in auto manufacturing, where top global competitors are maximizing plant productivity, 80 percent of companies are small, traditional shops, with fewer than ten employees. These subcontractors provide low-cost labour to global parts makers and assemblers and have one-tenth the productivity of producers in the top 10 percent.

Some global companies are already working with their small suppliers, providing technical know-how and even access to capital for new equipment and technology. Mexico needs more of this kind of development. Most important, Mexico needs to become a place where those who do not play by the rules are penalized and where law-abiding companies grow and prosper — and inspire others to emulate their success.

Jaana Remes is a partner at the McKinsey Global Institute. Luis Rubio is chairman of Mexico’s Centre of Research for Development.

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